Shreyas Balasubramanian, Delhi, 5 August 2024
As the Indian stock market continues to soar to new heights, with the Sensex recently crossing the 80,000 mark, a growing chorus of analysts and economic indicators are sounding alarm bells about inflated valuations and the potential for a significant market correction. While bullish investors celebrate the seemingly unstoppable rise, a closer look at key metrics and expert opinions suggests that the current rally may be built on shaky foundations.
The Buffett Indicator Flashes Red
One of the most telling signs of market overvaluation comes from the so-called “Buffett Indicator,” which compares a country’s total stock market capitalization to its gross domestic product (GDP). The current reading of 1.4 for India is significantly higher than its historical average of 0.89, indicating substantial overvaluation. Worryingly, this level now exceeds that seen in the lead-up to the 2008 Global Financial Crisis, a period notorious for its market bubble.
Price-to-Earnings Ratios Paint a Concerning Picture
Another key metric pointing to overvaluation is the price-to-earnings (P/E) ratio. Generally, a P/E ratio above 23 is considered a signal for overvaluation. Currently, the overall Sensex P/E ratio stands at 24.3, already in the danger zone. However, the situation becomes even more pronounced when looking at mid-cap and small-cap indices, with P/E ratios of 32.9 and 37.9 respectively. These elevated ratios suggest that investors are paying a premium for stocks that far exceed their current earnings potential, often based on optimistic future projections that may not materialize.
Sector-Specific Bubbles
The overvaluation phenomenon is particularly acute in certain sectors that have captured investor imagination. Defense and railway stocks serve as prime examples of this trend.
An analysis of seven major defense stocks reveals that while their combined revenues grew by 49% and profits by 120% between 2020-21 and 2023-24, their market capitalization skyrocketed by an astounding 306%. Individual cases are even more extreme, with Mazagon Dock Shipbuilders seeing its market cap surge by 775%, far outpacing its revenue and profit growth of 134% and 285%, respectively.
The railways sector paints a similar picture. Five key railway stocks saw their combined market capitalization balloon by 411%, despite more modest revenue and profit growth of 66% and 49%, respectively. The Indian Railways Finance Corporation (IRFC) stands out, with its market cap growing by over 520%, while revenues increased by only 69% and profits by even less at 45%.
Ajay Bodke, an independent market analyst, warns that much of this growth is predicated on “irrational exuberance” and “fanciful narratives” that assume flawless execution of projects and ignore potential hurdles like regulatory delays or cost overruns.
Retail Investors Fueling the Fire
A significant driver of this market rally has been the surge in retail investor participation. The Economic Survey 2023-24 highlights that individual investors’ share in equity cash segment turnover reached 35.9% by the end of FY24, while the number of demat accounts rose from 11.45 crore in FY23 to 15.14 crore in FY24.
While increased retail participation can lend stability to markets, it also raises concerns about inexperienced investors and speculators chasing high returns without fully understanding the risks. The survey warns of “the possibility of overconfidence leading to speculation and the expectation of even greater returns, which might not align with the real market conditions.”
The Dangers of Derivatives
The surge in derivatives trading among retail investors is particularly worrying. The Economic Survey notes that while derivatives can offer “outsized gains” and cater to “humans’ gambling instincts,” they are often a losing proposition for most investors. A 2023 paper by the Securities and Exchange Board of India (SEBI) found that 9 out of 10 retail investors in the derivatives segment lost money. The survey cautions that “a significant stock correction could see losses, which are more considerable for retail investors participating in capital markets through derivatives.”
A Call for Caution
Market strategists warn that the biggest threat to overvalued markets often comes from unforeseen events. Vijayakumar of Geojit Financial Services notes, “The concern I have is that big crashes in the market happen for previously unforeseen reasons. Known factors will not cause big crashes.”
Recent history bears this out, with the COVID-19 pandemic and the Russian invasion of Ukraine serving as prime examples of “black swan” events that triggered significant market corrections. When valuations are already stretched, the impact of such unforeseen shocks can be particularly severe.
While the current bull run has undoubtedly created wealth for many investors, the mounting evidence of overvaluation calls for a cautious approach. The Economic Survey 2023-24 strikes a balanced tone, acknowledging that increased retail participation is “hugely welcome” while also warning that “excessive valuations” are a “harbinger of market instability rather than market resilience.”
Mark Matthews of Julius Baer echoes this sentiment, stating, “I wish there would be a pullback in the Indian market. It is becoming overvalued… I wish it would pull back and rest a little bit.”
For investors, the key takeaway is the need for prudence and a long-term perspective. While the allure of quick gains in a rising market is strong, history shows that those who chase momentum without regard for fundamental valuations, often pay a heavy price when the music stops. As India’s economy continues to grow and evolve, its financial markets will undoubtedly play a crucial role in capital formation and wealth creation. However, sustainable growth requires a balance between enthusiasm and realism. As the current rally stretches valuations to historically high levels, both regulators and investors would do well to heed the warning signs and proceed with caution.
